Friday, 30 August 2013

Raghuram Rajan, the new governor of the Reserve Bank of India, can turn the crisis engendered by the rupee's fall into an opportunity to reform the objectives and the instruments of Indian monetary policy.

A Government of India committee, the Financial Sector Legislative Reforms Commission, has recently suggested that the RBI Act of 1934 be repealed and replaced with a new law more suitable for a modern central bank. Anchoring expectations on inflation would require narrowing the objectives of monetary policy and bringing in financial sector reforms that can strengthen the presently weak transmission mechanism of monetary policy.

The Indian rupee has seen one of the sharpest falls in recent times. Although the path ahead is not easy, reforms that have been delayed in the past are now manifestly necessary. Indians have to recognise that there are structural reasons behind the behaviour of the rupee that go beyond the decline in GDP growth and the large current account deficit.

After the 2008 crisis the currency was largely allowed to float, but the move from a pegged exchange rate was not accompanied by a well-defined nominal anchor that could guide price expectations. Though a floating exchange rate facilitated an independent monetary policy, the policy objective was not clearly articulated.

On a number of occasions the RBI argued that price stability or an inflation target could not be its sole or even main policy objective. The RBI preferred the approach of following multiple objectives.

India has now seen nearly seven years of 8-10% consumer price inflation, higher than RBI's target rate of 4-5%. In recent surveys, inflationary expectations of households have risen to above 10%. The demand for gold, which is largely imported, has risen as households have attempted to hedge inflation, putting pressure on the current account. These imports are effectively capital flight from India. All these factors increase the sense of crisis - but monetary reforms may now rise higher up the policy agenda than would otherwise be the case. The new governor has the chance to show his mettle.

Monday, 19 August 2013

Rupee defence strategy has deepened the gathering gloom on the India growth story.

The defence of the rupee is going horribly wrong. It has damaged two sources of hope for a growth pick-up in India - monetary policy easing and India's commitment to economic reform. When Chairman Ben Bernanke of the Fed talked about tapering quantitative easing in the US, it was expected that there would be pressure on emerging market currencies. Countries with weaker economies, and with larger current account deficits were likely to see more currency volatility. Instead of talking about this source of pressure, which all emerging markets faced when the dollar started appreciating, the government decided to step in to defend the rupee.

Evidence from across the world shows that a currency defence often fails. Every government trying to stabilise a currency is, therefore, fully aware of the chances of failure. A careful cost-benefit analysis of its strategy is thus an important pre-condition to initiating a defence. Since the global currency turmoil started, the government has been rolling out measures such as currency market controls, import duties on gold and silver, bans on purchase of gold coins and tightening of capital controls to stabilise the rupee. These dirigiste solutions seem oblivious of their likely impact on market expectations. They are based on central planning notions of bans and restrictions being the solutions to the economy's problems.

First came restrictions on currency derivatives markets by Sebi and the RBI. These markets inform people of expectations about the currency. This information may be unpleasant. The government may disagree with it. But instead of listening to what the market was saying, the authorities chose to try to silence it. Restrictions reduced the extent to which people could hedge their currency risk. This was a bad move, especially since the rupee was expected to become more volatile. It made investors less willing to buy rupee assets. Trading volumes on domestic currency derivatives markets fell sharply and the cost of hedging increased. Instead of making rupee assets more attractive, these measures have made them less attractive. Further, the restrictions have undermined the market's confidence about the government's commitment to financial market liberalisation.

Next came the liquidity squeeze and an increase in short-term interest rates. The complicated strategy hoped to keep long-term interest rates low. This, too, failed. When the rate hike saw a transmission of higher rates to treasury bill rates, long-term bond yields and deposit rates, it became increasingly clear that sooner or later bank lending rates would go up. To prevent that, the RBI kept the repo and CRR rate unchanged. This left the market in complete confusion. Were interest rates going to rise or fall? Statements by the authorities that the tightening was temporary till the rupee stabilises provided little comfort. Could the currency stabilise before US monetary policy went back to normal? How long was "temporary"? In an environment in which a monetary easing was expected to help push up growth, this sudden tightening was a shock. Interest rates are still high. The measures have undermined confidence about monetary policy easing.

After the liquidity squeeze failed to restore rupee stability, came tariff hikes and restrictions on gold and silver imports and tightening of capital controls under FEMA. Restrictions have been imposed on capital outflows by firms and households. Already, firms were suffering from the difficulties of the policy environment. If some of them were going to stay healthy by investing abroad, that was made more cumbersome. Hardly any money was going out by individuals investing abroad. But putting a restriction on these trickles sent out a bad signal to an already nervous market. These measures did not inspire confidence that the government's focus was investment and growth. Worse, they suggested that India's economic reforms are not deep-seated and can be reversed for short-term ends.

With the opening up of trade and the capital account, the currency market has grown very large. Old solutions, like selling a few billion dollars from our reserves to prevent appreciation, no longer work. Out of the three corners of the impossible trinity, a country can choose only two. For the last two decades, India had chosen to move towards an open economy and a flexible exchange rate. In the face of the QE tapering, it means choosing between rupee stability and lowering interest rates. But the government did not like having to make the choice. It wanted both. The only way to control the currency in such a situation is to close the economy. When the size of the market has shrunk adequately, the RBI can intervene and prevent depreciation without much loss of reserves.

If the rupee remains volatile, the government has to choose to either roll out the next measure it has on its list, or to find an exit route. FEMA allows the RBI and government to shut off all cross-border transactions for sale and purchase of assets. The market believes that as long at the rupee defence strategy remains in place, the authorities might impose restrictions on various other capital flows. This expectation has caused further gloom.

We should not lose sight of the big picture of Indian economic policy. The story of the last 20 years is one of slow but steady economic reform resulting in 7 per cent trend GDP growth. The day we walk away from the promise of slow but steady reform, the expectation of future productivity growth is shattered. This adversely affects the credit rating of India, stock prices, investment in India by locals and by foreigners, and capital flight from India. The needless battle the government has picked on the rupee, and the measures it has taken, have reinforced the already growing despondence about economic reforms. It has raised new questions on the India growth story. The government must immediately undo all the steps that have reversed economic reforms of trade or finance or capital account liberalisation. Otherwise, we will suffer deeper damage to the prospect of high GDP growth.

Friday, 16 August 2013

Indian companies have borrowed heavily abroad, attracted by low interest rates. It is feared that a depreciation of the rupee will hurt corporate balance sheets adversely and make the economic situation worse. Measurement of firm currency exposure shows that, fortunately, this is not the case. All large and medium sized Indian companies, who are usually the ones who borrow in dollars, expected rupee depreciation. Most of them have hedged their currency exposure. This is not surprising considering the large current account deficit, the slowing economy, higher inflation and the expected increase in US interest rates coupled with the last few years of RBI's policy of not intervening in the rupee-dollar market.

Some exporters have a natural currency hedge when they borrow, some companies chose not to borrow abroad, while still others hedged in the derivatives markets. This behaviour is perfectly rational. If a depreciation was expected, it made little sense for a company to take a dollar loan, even if it was cheaper, whose payment would become more difficult in a couple of years.

Table 1:

Gain from Appreciation

Neutral

Gain from Depreciation

2002-2004

300

1539

17

2011-2013

0

1201

81

Source: Author's calculations

Table 2:

Firms borrowing abroad

(March 2012)

Total number of firms:

8382

Firms borrowing abroad:

843

Amount borrowed abroad:

USD 236.66 billion

Source: Prowess, CMIE.

The data for firms borrowing abroad is available in the CMIE prowess data base. We see that in March 2012, out of 8,382 companies, only 843 companies, or 10% of all Indian firms, borrowed abroad. The data suggests that today also the figure should be roughly the same. However, exposure may arise in many other ways as well. For example, if a firm imports raw materials, but cannot pass on the increase in costs, its profit margins would decline.

Figure 1: External commercial borrowings (per month)

Hence we measure unhedged currency exposure of Indian firms. This measure uses an analysis involving daily stock market and currency data and, therefore, can be estimated till end July 2013. It measures whether the company loses or gains in value when the rupee-dollar rate moves, or the average impact of a 1% currency depreciation on the stock price. If the firm has hedged, then the stock price does not gain or lose value when the currency moves. We measure exposure for 1,282 of the listed firms that have fairly adequate liquidity.

First, we look back at the 2002-04 period. Here, there was large-scale trading by RBI on the currency market aiming to prevent rupee appreciation. Most market participants expected the rupee to appreciate. At this time, it was advantageous for firms to set themselves up to profit from the expected future appreciation by invoicing in rupees, hedging export proceeds, leaving imports unhedged, borrowing in dollars, etc. Our analysis shows that there were 300 large firms who had positioned themselves to gain from appreciation. There were 1,539 firms who did not have a statistically significant exposure. There were only 17 firms who did not expect an appreciation and would be hurt by it.

If, in that situation, a sudden and unexpected depreciation had taken place, it would have generated a substantial adverse impact upon these 300 firms who were betting on appreciation.

Then we turn to the latest two years ending in July 2013. Our analysis shows that there are no firms who have set themselves up to gain from appreciation. There are 1,201 firms who have no statistically significant exposure. There are 81 firms which stand to gain from depreciation. These are firms who would have invoiced in dollars, left exports unhedged, hedged imports, and not borrowed in dollars. Most firms were hedged. There was not a single firm who was expecting a rupee appreciation and took positions accordingly. The unhedged exposure, though little, is on the other side.

There is, of course, nothing really surprising in this. Few observers of the Indian economy were expecting a strong or stable currency. When the exchange rate is managed, firms have an incentive to throw caution to the winds. As long as the firm does not have to pay the hedging costs itself, it is always cheaper to borrow in dollars. In the past when the rupee-dollar exchange rate was kept stable, firms left their currency exposure unhedged.

This has two implications. First, firms take on more currency risk under a managed exchange rate. In 2002-04, there were 317 firms who were betting on exchange rate fluctuations. The floating exchange rate, which has prevailed from March 23, 2007, onwards, has induced fear in firms and fewer firms are leaving their currency exposure unhedged.

The second important implication is that at present rupee depreciation does not have an adverse impact for big and medium sized Indian firms that constitute the dataset. There are 81 firms who will actually gain from a large rupee depreciation. There are no firms who stand to lose from a rupee depreciation.

However, there are a large number of firms with interest rate exposure. These are firms who have borrowed domestically and expected an easing of monetary policy. These firms are much large in number. In fact, almost every firm has some borrowing. This borrowing is largely unhedged as there are few ways to hedge it in Indian markets today.

Monetary policy in an open economy involves making a choice between ensuring low currency volatility or ensuring low interest rate volatility. In both 2002-04 and in the last two weeks RBI intervened to provide low currency volatility. In this choice between currency volatility and interest rate volatility, most firms today would have a preference for higher currency volatility rather than interest rate volatility.

Looking forward, these episodes have important policy implications. Countries have experienced acute distress when a large part of the corporate sector had a certain bet (for example, betting on rupee depreciation) and things suddenly went the other way. It is good for India if firms are hedged. It makes the economy more resilient.

Sunday, 11 August 2013

The new governor-designate of the Reserve Bank of India (RBI), Raghuram Rajan, faces a formidable set of challenges: falling Indian growth, rising financial market interest rates and doubts whether the authorities have the will and the instruments to defend the plunging rupee.

Rajan, currently the Finance Ministry's chief economic adviser and honorary economic advisor to Prime Minister Manmohan Singh, has an enviable reputation as a former chief economist at the International Monetary Fund and the man who predicted the 2007-08 financial crisis. His appointment to replace Duvvuri Subbarao in early September comes at a crucial time.

The US Fed's moves towards tapering off its quantitative easing (QE) bond purchases have led to problems for the currencies of many emerging market economies with large current account deficits, but nowhere has the fall-out been greater than India. Having earlier held up well in comparison to other currencies (such as Turkey, South Africa and Brazil), the rupee has come under heavy pressure in the last two months.

The Indian authorities have reacted to the sharp depreciation by implementing a host of measures including engineering higher bank interest rates through a liquidity squeeze on the banking system, and imposing regulations that reduce participation in currency derivatives markets. However, the RBI has pointedly left unchanged its official interest rates.

Measures to reduce anti-rupee speculation have been ineffective, with the currency falling below the Rs 60 per dollar level that the authorities sought in the past to defend.

There is considerable confusion in the market. Will the RBI defend the rupee with further tightening and capital controls? When will it reverse its measures? One of the most difficult issues that the new governor faces is that many observers believe that the RBI's rupee policy, its implications for the domestic market, and the exit strategy were not well thought out in the first place.

The failed defence of the rupee has exposed clear policy shortcomings including lack of transparency and interference in financial markets. All this will be very costly for India. The governor-designate has pointedly said he has 'no magic wand' to resolve these problems. Nevertheless, expectations on him to make the right decisions are very high.

Since the 2008 crisis, the Indian exchange rate policy has, in general, been to allow the rupee to depreciate. First, this was because the fall in the rupee mainly reflected the dollar's appreciation, so there was little India could do about it.

Second, the depreciation was useful as it could help correct the large current account deficit. It kept the real exchange rate from appreciating as India has a higher inflation rate (at about 8-10%, measured by consumer price inflation) than its main trading partners.

Third, the RBI holds about $280bn of foreign reserves. This comfortably covers six months of imports, but would be insufficient if the RBI started to sell, say, $8-10bn a day to defend the rupee.

Fourth, increasing the RBI's official benchmark lending rates was considered inappropriate as the Indian economy has been slowing down, investment sentiment is weak and - even though inflation is higher than the authorities would like - price rises are starting to abate given the sharp deceleration in demand.

Why did the RBI react so strongly this time? The rationale for the sudden sharp defence of the rupee at Rs60 remains a mystery. Unlike the Indian government, many Indian companies have a large external debt. Defending their balance sheets could have been the ostensible reason to defend the rupee. In reality, however, most of these corporates expected a rupee depreciation and were hedged beforehand. An alternative reason could have been the fear of further inflation. However, this cannot be a strong justification, as core inflation is now below the levels reached in the last five years when the RBI didn't react.

The RBI started easing monetary policy in the beginning of 2013, but last month saw a sudden change as the rupee was seen to be too volatile. The RBI's action to protect the rupee did not include raising the repo rate or the cash reserve ratio, which have been the main tools of monetary policy in the last decade. Its flurry of actions led to a sharp rise in the overnight call money rate, the Treasury bill rate and the 10-year government bond yield. Auctions of government bonds failed, as the RBI failed to meet investors' yield expectations.

The RBI's decision to leave the repo rate and the cash reserve ratio unchanged has been a bid to persuade the domestic market that liquidity tightening was only temporary. The financial markets viewed this as a signal that monetary tightening would soon be reversed. The rupee depreciated further and the RBI and state-owned banks are now reported to be selling dollars.

The lack of rupee recovery has resulted in a wedge between the onshore and the large offshore (non-deliverable forwards) market for the rupee, a very tight domestic liquidity situation, higher deposit rates by some private sector banks and a further loss of confidence in Indian policy-making.

Monday, 5 August 2013

It should be left to an independent central bank with a clear brief and instruments

Indian monetary policy law, like that of many advanced and most emerging economies, needs to define the objectives of monetary policy. The sudden shift away from inflation and growth to a defence of the rupee has caused a lot of confusion. In addition, the law needs to lay down the instruments of monetary policy. This could be the repo rate or any other chosen rate. Once this is done, the RBI needs to be made accountable and given independence in order to achieve these objectives.

Today, even if the government achieves Rs 60 to the US dollar, the cost of defending the rupee is too high. Beyond the tangle that the RBI is now in, these events point to the larger question of monetary policymaking in India. Decisionmaking on monetary policy in India will become increasingly difficult in the next two years. The US Fed will stop easing and US interest rates will rise. If the RBI leaves interest rates in India unchanged, Indian assets will become relatively unattractive. This will put pressure on the rupee to depreciate. If the RBI increases interest rates to prevent this from happening, growth in India will suffer. If it lowers rates, there could be additional pressure on the rupee. There may be episodes of high exchange-rate volatility, such as when the Fed announces the date of reducing its purchase of treasury bills, buys less bonds, stops them altogether, or when it starts reducing the size of its balance sheet.

It is well understood by now that once the capital account is open, a country has to choose between pegging the exchange rate and pursuing an independent monetary policy. The impossible trinity tells us that with an open capital account you cannot have both a pegged exchange rate and monetary policy independence. If the business cycles of the Indian economy were perfectly aligned with those of the US, there would be no problem. But if the US is going to raise rates, we have to make a choice: let the rupee be flexible or peg the rupee to the dollar and tighten along with the US. The middle paths that we try to follow are fundamentally problematic and may only have some limited, short-term impact. Meddling with the exchange rate can only be done by distorting monetary policy, and anyone who says otherwise is trying to obfuscate matters.

As the experience of the last couple of weeks shows us, decisions about monetary policy are not straightforward. First, there is no answer to what the correct level of the currency or interest rate should be. Countries witness deviations of the real effective exchange rate from the historical neutral level. This could be because the real effective exchange rate is not always the market equilibrium, as financial markets are influenced by many forces, or it could be that fundamentals, such as changes in productivity, are pushing it to a new value. Whatever the case may be, manipulating the real effective exchange rate to keep it constant or at the correct level, after accounting for productivity changes, at all times, is an impossible task.

Second, whether a currency should strengthen or weaken to stabilise the economy depends on what phase of the business cycle the country is in. When the economy is slowing down, a weaker rupee will help it recover, when it is overheating, a stronger rupee will help prevent inflation from rising.

Third, any policy action will have an effect not just on the currency but also on interest rates, growth, the fiscal deficit, the current account deficit, business sentiment and investment. There are costs and benefits. Both need to be considered.

These issues suggest that monetary policy actions should be made after thorough analysis, discussion and considering different points of view. Knee-jerk reactions that focus only on one element of the impact of those policy changes are bound to be troublesome. Since governments often come under political pressure to do something, if the job of making monetary policy can be influenced by the government, it results in macro-economic mismanagement. It was an understanding of these difficulties in monetary policymaking, after many episodes of painful mismanagement that led to years of inflation, recession, stagflation and largescale unemployment, that led advanced economies to hand over the task to central banks. They were given independence from the government and required to have structures such as monetary policy committees, which allowed informed decisions and a diversity of views.

Why do governments prefer such arrangements? Why do they allow central banks to be independent and pursue policies that are so important for the whole economy? One reason is the shift in responsibility, particularly for all the costs. Remember that there will always be some losers and some winners from any policy decision. In other words, there will always be voices that say that a decision was wrong and point to the losses it creates. Once the public accepts that it is the central bank that makes these decisions, the impact of criticism of the government for inflation or for depreciation or appreciation is limited.

With the Indian economy opening up in the last two decades, the difficulties of monetary policymaking have increased. By now, there have been many government committees which have suggested that it is time for India to move to a modern framework for monetary policymaking. India needs a central bank with independence and accountability, and with a professional monetary policy committee that decides monetary policy actions using well-defined instruments of policy. The latest of such recommendations is by the Financial Sector Legislative Reforms Commission, which has also proposed a draft law. While it may be very tempting for the government to be able to shape monetary policy at a particular point of time, it needs to understand that it will be well served by such a framework.